Common issues with common control

Common control transactions are a difficult and subjective area of financial reporting, as there is presently no accounting standard that deals with them.

In this article, we consider how they are usually treated, and also look at the proposals of the current IASB project to standardise accounting for common control transactions.

How should you account for common control transactions?

Many groups of companies enter into agreements to restructure their group. This can occur for various reasons, including taxation, structuring, limitation of liability, or business simplification.

When these restructuring agreements are entered into, it is important to know whether common control exists or not as this determines the appropriate accounting treatment.

A transaction between two entities which are owned by the same ultimate parent is usually referred to as a “common control transaction.” Common control transactions are specifically scoped out of AASB 3 Business Combinations, which states that “a business combination involving entities or businesses under common control’ is a business combination in which all of the combining entities or businesses are ultimately controlled by the same party before and after the combination, and that control is not transitory.”

Australian Accounting Standards, and IFRS, do not currently specify how to account for common control transactions. In the absence of specific requirements, companies tend to provide relatively little information about such combinations, and report on them using one of several commonly accepted methods.

When does common control exist?

Two entities are commonly controlled when they have the same ultimate ownership. This ultimate control can be held by any of the following:

• A company or other entity
• An individual
• A group of shareholders that has an agreement to act collectively
• A family group which acts collectively (even where there is no formal agreement to do so).

While common control is easily determined where one party owns a controlling interest in both entities, other situations may be more complex:

Example 1

Company A and Company B are each owned by three shareholders, each of whom owns 33% of the shares of both companies. The three shareholders are unrelated, and do not have any shareholders agreement or similar arrangement which compels them to vote or act together.

Company A and Company B are not under common control, even though they are owned by the same three parties, as no individual or group has control of either company.

Example 2

Company C and Company D are each owned by three shareholders, each of whom owns 33% of the shares of both companies. However, two of the shareholders are brothers, and have a history of always acting and voting together in making decisions about the management of the two companies..

Company C and Company D are under common control, since there is a single family group which acts collectively to control the two entities.

Accounting for common control transactions

While no specific requirements exist within Australian Accounting Standards, the there are two commonly accepted methods of reflecting common control transactions in financial statements:

1. The acquisition method as set out in AASB 3; or
2. The pooling of interest method

The acquisition method under AASB 3 is the same process that would be used for the acquisition of a business which was not under common control.

The pooling of interest method is sometimes referred to as “merger accounting”, "carry-over accounting”, or the “predecessor values method.”

We believe that if an entity does not adopt an accounting policy of using the acquisition method under AASB 3, or if the transaction is not in substance an acquisition of a business, the pooling of interests method should be applied when accounting for business combinations under common control.

AASB 3 makes no reference to the pooling of interests method, other than to reject it as a method of accounting for business combinations which are not under common control. Various local standard-setters have issued guidance and some, including US GAAP and UK GAAP allow or require a pooling of interests type method in particular circumstances to account for business combinations under common control.

The pooling of interests method involves the following:

While both methods – the pooling of interests method and the acquisition method - are permissible under IFRS, in our view, for most common control transactions, the “pooling of interest” method is likely to be the more appropriate choice based on the following factors:

• It may better represent the substance of the transaction, being a group reorganisation rather than a genuine business acquisition.
• If the acquisition method were adopted, there would need to be an assessment of the fair value of the assets, including any previously unrecognised but separately identifiable intangible assets. This may be time-consuming, judgmental, and may incur substantial additional expense if specialist valuation services are required.
• The acquisition method may result in the recognition of additional goodwill. This appears inconsistent in principle with the requirement in Australian Accounting Standards that internally generated goodwill cannot be recognised. Furthermore, if additional goodwill were to be recognised as a result of this transaction, it would need to be tested for impairment annually – a potentially onerous exercise.

Example 3 – Application of the Pooling of Interest Method

Company S1 pays 80 to Company IP2 to acquire all of the shares in Company S3. The book value of Company IP2’s investment in S3 is 100 and the fair value of S3 is 130.

In applying pooling of interest method, the acquirer (S1) and the transferor (IP2) record the following entries, recognising the difference between the book value of the transferee (S3) and the consideration paid/received as an equity transaction with the shareholder (P) – i.e. as if S3 had been purchased for its book value of 100 and the difference of 20 paid back as a distribution made/contribution received.

Entries in S1:

Dr Investment in subsidiary (S3)                100

Cr Cash                                                                         80

Cr Contribution (equity)                                    20

To recognise contribution in S3

Entries in IP2:

Dr Cash                                                                     80

Dr Distribution (equity)                                   20

Cr Investment in subsidiary (S3)             100

To recognise disposal of S3

How will common control accounting change in the future

The International Accounting Standards Board is carrying out a research project on business combinations under common control to consider how to fill the gap in IFRS Accounting Standards. The objective of the project is to explore possible reporting requirements that would reduce the diversity in practice and improve the transparency and comparability of the reporting on such combinations.

The Board’s view is that companies should provide similar information about similar business combinations when the benefits of that information to investors outweigh the costs of providing it. The Board is suggesting that the acquisition method should be used when a business combination under common control affects non-controlling shareholders. That method is required by IFRS 3 for mergers and acquisitions between unrelated companies.  This reflects the fact that information about the fair value of the assets acquired and consideration paid in a common control transaction will be relevant to minority shareholders in determining that they were not unfairly disadvantaged by the transaction.

In all other cases, the Board is suggesting that a book-value method should be used. A single form of a book-value method would be specified in IFRS Standards.

Below is a flow chart which sets out the circumstances under which each method is appropriate:

Book value method

IFRS Standards do not refer to any book-value methods and do not specify how such a method should be applied. A variety of book-value methods are used in practice. In particular, the variations relate to:

a)     measuring the assets and liabilities received—the receiving company uses either the transferred company’s book values or the controlling party’s book values to measure those assets and liabilities.

b)     providing pre-combination information—the receiving company includes the transferred company’s assets, liabilities, income and expenses in its financial statements:

i.      either prospectively from the date of the combination, without restating pre-combination information; or

ii.      retrospectively from the beginning of the earliest period presented as if the receiving company and transferred company had always been combined, with pre-combination information restated.

Measuring the assets and liabilities received

The Board considered whether the receiving company should measure the assets and liabilities received at the transferred company’s book values or at the controlling party’s book values. Those book values would typically be identical if the controlling party has controlled the transferred company since the creation of that company. However, those book values could differ if, for example, the transferred company had previously been acquired from an external party (that is, a party outside the group), especially if that external acquisition was recent.

The Board has reached the preliminary view that, when applying a book-value method to a business combination under common control, the receiving company should measure the assets and liabilities received using the transferred company’s book values.

Measuring the consideration paid

The consideration paid in a business combination under common control can take various forms. Research for this project indicates that the consideration is usually paid in cash or in the receiving company’s own shares, but sometimes in non-cash assets or by incurring or assuming liabilities.

The Board's preliminary views are that:

a)      the Board should not prescribe how the receiving company should measure the consideration paid in own shares when applying a book-value method to a business combination under common control; and

b)     when applying that method, the receiving company should measure the consideration paid as follows:

i.   consideration paid in assets—at the receiving company’s book values of those assets at the combination date; and

ii.   consideration paid by incurring or assuming liabilities—at the amount determined on initial recognition of the liability at the combination date applying IFRS Standards.

Reporting the difference between the consideration paid and assets and liabilities received

The Board’s preliminary views are that:

a)      when applying a book-value method to a business combination under common control, the receiving company should recognise directly within equity any difference between the consideration paid and the book value of the assets and liabilities received; and

b)     the Board should not prescribe in which component, or components, of equity the receiving company should present that difference. In practical terms, this means it may be taken either directly to retained earnings, or to a separate common control reserve.

Reporting transaction costs

In undertaking business combinations under common control, companies might incur transaction costs, such as advisory, legal, accounting, valuation and other professional fees and the costs of issuing shares or debt instruments.

The Board has reached the preliminary view that, when applying a book value method to a business combination under common control, the receiving company should recognise transaction costs as an expense in the period in which they are incurred, except that the costs of issuing shares or debt instruments should be accounted for in accordance with the applicable IFRS Standards.

Providing pre-combination information

In some cases when applying a book-value method, companies combine the assets, liabilities, income and expenses of the transferred company retrospectively. In other words, the receiving company’s financial statements are prepared as if the combining companies had always been combined, with pre-combination information restated to include the transferred company’s assets, liabilities, income and expenses from the beginning of the earliest period presented. In other cases, companies combine those items prospectively, that is, from the date of the combination, as is required for business combinations covered by IFRS 3. The prospective approach does not require the receiving company to restate pre-combination information.

The Board has reached the preliminary view that, when applying a book value method to a business combination under common control, the receiving company should include in its financial statements the assets, liabilities, income and expenses of the transferred company prospectively from the combination date, without restating pre-combination information.

Example 4 – Determining which method is appropriate

Company A has 2 subsidiaries, Company B and Company C. Company C Acquires Company B’s shareholding in Company D. This transaction is a business combination under common control. The Non-controlling interest shareholders are not a related party to Company C and have not consented to the application of the book value method.  Which method is the most appropriate method to account for this business combination under common control?

The first question to ask is – does the acquisition affect the non-controlling interest of the receiving entity?  In this case, it does. Company C has non-controlling interest which need to be considered.

Are the receiving entity’s shares traded in a public market? No, assume that Company C’s shares are not traded in a public market, therefore the following should be considered:

• the receiving company should be permitted to use a book-value method if it has informed all of its non-controlling shareholders that it proposes to use a book-value method and they have not objected (the optional exemption from the acquisition method); and
• the receiving company should be required to use a book-value method if all of its non-controlling shareholders are related parties of the company (the related party exception to the acquisition method).

The acquisition method should be applied, as the non-controlling interest is not related to Company C and have objected the application of the book value method.

This project is currently in the discussion paper stage, and therefore further changes to these proposals may occur before they are issued as final standards.

For more information

For any queries on common control please contact Ralph Martin ([email protected]) or Nadia Hattingh ([email protected]).